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Sunday, July 3, 2011

The Most Important Thing: Chapters 3 and 4

Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.

In these two chapters, Marks discusses what he believes to be the only market philosophy that works that doesn't require luck: purchasing below intrinsic value and selling higher than the purchase price.

Technical analysis involves studying past price movements in order to determine future price movements. Marks doesn't believe technical analysis works, and refers to some texts that have proven this. Momentum investing can work for a while, but it only works until it doesn't. This leaves the investor susceptible to holding the bag when the party ends, which can result in big losses.

When it comes to fundamental investing, Marks distinguishes growth from value investing. Too much of growth investing is based on a very uncertain future, and so he prefers the consistency delivered by value. He does concede, however, that correct prediction of growth (e.g. identifying the company that invents the next blockbuster drug) should lead to returns superior to those delivered from value investing; unfortunately, correctly predicting growth is difficult.

In Marks' opinion, therefore, investors should always compare value to price. Any asset, no matter how terrific, can trade at a price that is too high. For example, the Nifty Fifty were all great companies, but some investors in them lost 90% of their investment because they paid way too high a price. At the same time, even a poor asset can be worth buying at some low price.

The trick in all this is an understanding of market psychology. Marks argues that psychology is more important than economics or accounting for investors. Investors must be able to resist the urge to buy a stock that has risen and avoid a stock that has fallen. After purchasing a stock, it can still fall further. In this case, "being too far ahead of your time is indistinguishable from being wrong". In such cases, investors must be able to hold onto their convictions if they are right (and the market is wrong) without holding on too strong to a belief that may be erroneous, which isn't easy.